Why we should realise that sterling has been, and still is, much too strong

Why we should realise that sterling has been, and still is, much too strong

Posted by Michael O'Sullivan7326.40sc on March 16, 2018

Below is a graph, based on data supplied by the International Monetary Fund (IMF), showing real relative exchange rate movements between sterling and the Chinese currency, the yuan or renminbi, over the past 40 years.

The big story begins in the late 1970s when the inability of Keynesian policies to control inflation led to the economic policy consensus switching to monetarist ideas on how to control the economy. Fighting inflation became the primary objective and the weapons used to bring price rises under control were tightening monetary policy and raising interest rates, with base rates peaking at 17% in 1980. The inevitable result was that the UK exchange rate strengthened enormously, rising by over 60% between 1977 and 1982. It then dropped back a somewhat, especially after the UK dropped out of the Exchange Rate Mechanism in 1992, before increasing strongly again in the late 2000s.

In the meantime, China – which has been a reasonable proxy for the whole of the Pacific Rim just as sterling has reflected what was happening in most of the West – adopted completely different policies. When the Chinese became part of the trading world around 1980, their economy was very uncompetitive. This situation rapidly changed, however, partly because the introduction of market forces dramatically increased the efficient use of resources and partly because there was a large nominal devaluation of the Chinese currency. The result was that the Chinese real effective exchange rate fell between 1980 and the early 1990s by about 75%, before slowly strengthening - to a strictly limited extent - over the next 20 years.

The UK reaction to this huge increase in Chinese competitiveness was not, however, to try to match it but to proceed in exactly the opposite direction. From the late 1990s onwards, sterling became stronger and stronger – rising by over 50% between 1995 and 2007 – as a result of new policies which encouraged on a massive scale the sale of UK assets to foreign interests. This change was achieved by abolishing in 1999 the Monopolies and Mergers Commission, with its public interest tests on takeovers, and replacing it with the Competition Commission which was only concerned with competition but not ownership or control. Further encouraged by the 2002 Enterprise Act, everything in the UK became up for sale to foreign interests – our ports, airports, football clubs, rail franchises, power companies, swathes of property and much else. Between 2000 and 2010 net sales to foreign buyers of UK portfolio assets – shares in existing companies, bonds and property, but excluding direct investment in factories or machinery – came to £615bn, which was around half our annual GDP at the time. No wonder the pound became so strong.

Deindustrialisation

The result of these policies, however, was that the UK’s industrial base, and hence its economy as a whole, was greatly weakened. As late as 1970, about 30% of the UK’s GDP came from manufacturing. It now accounts for less than 10% - 9.7% at the last count and still drifting downwards. This has had three disastrous effects. First, productivity increases are much easier to secure in manufacturing than they are in services, which is why the decline in manufacturing has a lot to do with the much slower increases in productivity we have seen recently. Second, the collapse of much low- and medium-tech manufacturing has had a huge impact on increasing the disparity in living standards between London and the rest of the country. In 2016, average Gross Value Added per employee was £44k in London, while in Wales it was £18k. Third, the decline of manufacturing in the UK has left us with insufficient goods to sell to the rest of the world to pay for our imports. Despite the large export surplus we have on services - £95bn in 2016 - our goods deficit of £136bn meant that we had an overall trade deficit that year of £40bn.

This is not, however, the end of the story. The damage done by our having a grossly overvalued currency has gone much further than this.

Imbalances

Investment Most types of run-of-the-mill manufacturing in the UK are unprofitable at the moment because we charge out our labour and overhead costs to the rest of the world at too high a rate. This is because our exchange rate is much too high in relation to our manufacturing productivity. As a result investment in UK industry is far too low. The key to increasing productivity is investment in mechanisation, technology and power – essentially activities which occur in the private manufacturing sector where profitability prospects are crucial, and without which investment will not take place whatever else is done to encourage it. In the UK we invest less than 16% of our GDP on investment of all kinds – compared with a world average of 26% and nearly 50% in China. Worse than this, however, the proportion of our GDP which goes to machinery, technology and power is less than 3% - and by the time depreciation is taken into account, nothing is left. This is by far the most important reason why productivity growth in the UK is so low.

Balance of Payments If a trade deficit of about £40bn a year was the only adverse factor in our annual balance of payments, it might be manageable. Unfortunately, however, our foreign payments position is much worse than this. Mainly because of the need to finance cumulatively larger deficits, our net income from abroad has got increasingly large and negative - £50bn in 2016, while at the same time our net transfers abroad – payments to the EU., remittances abroad by migrants and our aid programmes have recently doubled – to £22bn in 2016. The overall outcome is that in recent years we have had total annual balance of payments deficits in the region of £100bn each year – about 5% of our GDP.

Debt The volume of debt supporting the UK economy has grown enormously in recent years. The UK’s monetary base is now some 14 times the size it was in 2000. The main reason why our debts are so high – both as individuals, through our government and as a nation – is that our huge balance of payments deficit syphons demand out of our economy which has to be replaced by unfunded expenditure – i.e. borrowing – to avoid the economy violently contracting. This borrowing primarily has taken the form of government deficits but also a recent large increase in consumer debt. There is no way in which government borrowing is going to be reduced if we have a large foreign payments deficit because one is the mirror image of the other.

Inequality In recent decades, there has been a relentless increase in inequality with at least three dimensions – between regions of the country, between generations, and in socio-economic terms as those who are already richer have got much richer while most of the population has seen little or no increase in its wealth. The main cause of regional inequality is deindustrialisation. The inter-generational inequality stems partly from lack of investment in housing and partly from relatively poor training and job opportunities. Disparities in wealth and life chances have been fanned by the ultra-low interest rates and by Quantitative Easing which have been triggered by the need to use increasing debt to fuel the economy, providing very large increases in the prices of assets such as housing and shares for those rich enough to own them.

Solutions

The only long-term solution to these problems is to use a much more competitive exchange rate to create conditions where it is worth investing in low- and medium-tech industry in the UK. This will require an exchange rate of close to parity with the US dollar and maybe €0.85 in the case of the euro. If we can reindustrialise – at least to get manufacturing as a percentage of GDP up to around 15% - this will bring our balance of payments under control. This, in turn will reduce the economy’s dependence on increasing debt, as well as rebalancing the income earning capacity of the regions. It will enable us to build more housing and to provide better training and job opportunities for millennials while creating a sufficiently robust and attractive economy to contain increasing wealth and life chance inequality. There are solutions to our economic ills!

Why has this been allowed to happen?

Why don’t we use a more competitive exchange rate to provide the necessary – even if not the sufficient - conditions for getting our economy to perform very much better? The reason is that very few of those who form public opinion in the UK are involved in manufacturing and are thus in a position to experience what our competitive problem really is. We have ample natural advantages in services – our geography, our language, our legal system, our universities, our financial services talent – which manufacturing almost entirely lacks. Services and high-tech manufacturing, neither of which are very price sensitive, are both comfortably able to survive and prosper with an exchange rate much higher than the one which most manufacturing needs. Our problem, however, is that most of our exports are still goods rather than services and we cannot pay our way in the world and, as a result, avoid running up more debt as our economy becomes more and more unbalanced and unequal.

Indeed, if we carry on as we are, we are likely to see an unending continuation of the current situation where most of the UK’s population have seen no increase in their real incomes for the past decade, while the wealthier get ever better off. This is a future which bodes very ill for us both economically, socially and politically. It is also one which pays a very high price for the other short-term benefits there are from too high an exchange rate – cheap holidays abroad and low import prices.

If, therefore, the UK is to avoid stagnating for the foreseeable future, with all the calamitous consequences that this will bring in train, we need to take a leaf out of the book of the Pacific Rim countries. Their stunning success over the past few decades was not an accident. It happened because they adopted economic policies orientated towards competitiveness which we now very urgently need to copy.